Country risk management handout, diversification by Gloria Armesto, Kasey Phifer, Alina Sachapow
Country Risk Management in Global Financial Markets Alina Sachapow, Gloria Armesto & Navi Phifer 20 Dec 2011 Country risk refers to the economic, political and business risks that are unique to a specificcountry and might result in unexpected investment losses. There are many ways to avoid or at leastminimize possible complications related to country risk. Diversification of investment and types ofsecurities is the best way to protect a portfolio from being seriously affected by negative events. The term diversification describes “a risk management technique that mixes a wide variety ofinvestments within a portfolio.”1 This is aimed at reducing the risk of an investment in order tostabilize or increase the return on it. The most important thing to do before investing anywhere is a thorough analysis of themarkets and the countries an investor plans to go to. Only when knowing the risks and opportunities ofthe specific securities and countries, it is possible to find the right investment and diversificationstrategy. In the case of Japan we found out that it has a high contagion risk that leads to a certainmarket hazard, a high risk of natural disasters, and an imminent sovereign peril, whereas Brazil israther facing political, inflationary and transfer risks. A well-diversified investor can utilize thisinformation to develop a wise diversification strategy. The first choice concerning diversity of investment is deciding where to invest. There are threetypes of markets to choose from: Firstly, developed markets consist of the largest, most industrialized,politically stable economies. These markets are considered the safest for investments. Japan, Franceand Canada enter under this category. Emerging markets experience rapid industrialization and oftendemonstrate extremely high levels of economic growth. These markets are riskier than developedmarkets and have more political uncertainty. Under this category are Brazil, China and India. Lastly,frontier markets are usually smaller than emerging markets and can be very risky and have low levelsof liquidity, but they offer the potential for above average returns over time. Examples of frontiermarkets include Nigeria and Kuwait. An investor can choose to invest entirely in a specific region like Europe, or entirely in aspecific country, but this wouldn’t be prudent. The reason is that not every risk can be diversified. Therisk that actually can almost be eliminated is called unsystematic risk. It is attributed to a certaincompany or industry. Systematic risk is harder to avoid because it includes country risks that cannotbe controlled by the markets as the inflation rate, exchange rate, political risk, or the peril of naturalcatastrophes. If an investor chooses to only invest in one country these country specific systematicrisks cannot be overcome.2 Therefore investors can decide to invest in several countries to convert thesystematic risks of certain countries into unsystematic risk that can be diversified with the help anddifferent situation of other countries. Diversification works best when the returns of the single1 http://www.investopedia.com/terms/d/diversification.asp#axzz1h1Dl6Wke accessed on 20 Dec 20112 “Fundamentals of Corporate Finance”, Brearley, Myers, Marcus, 6th Ed. Chapter 11, page 328
Country Risk Management in Global Financial Markets Alina Sachapow, Gloria Armesto & Navi Phifer 20 Dec 2011investments are negatively correlated. This is why it makes sense to invest in different countries toequal out the risks that evolve.3 So, if, for example, Japan has a high risk of contagion and Brazil doesnot, it is advisable to invest in both the countries to reduce the impact that Japan’s contagion risk has. Therefore it is better to spread investment among developed, emerging and perhaps frontiermarkets to maximize diversification and minimize risk. The second important choice to make is what investment vehicles to invest in. The investorshould allocate among short-term and long-term securities as different maturities represent a differentlevel of risk: stocks, bonds, treasury bills, commercial papers, mutual funds, etc. The choice dependsmostly on investor’s individual knowledge, experience, risk profile and return objectives. There aremany different stock valuation methods available, falling under the category of fundamental ortechnical analysis, that are used to forecast an industry’s or company’s future performance. The Price-Earnings (PE) method, Dividend Discount model, Capital Asset Pricing Model (CAPM) and even theArbitrage Pricing model all have their own unique shortcomings and failures, but can help to create agood investment strategy.4 An example of a diversified portfolio could be buying government bonds in Brazil (emergingmarket), commercial papers from an AAA-rated company in Japan and stocks from a company inFrance. In this way, the investor can avoid credit risk with the government bonds and receive a riskpremium from the stocks in France. Since France is a developed market, the risk of default, thepolitical and economic risk are very low. On the other hand, Japan is also a developed market, but hasa high economic risk due to its vulnerability to natural disasters and a high contagion risk since it isalso vulnerable to falls and rises in global demand. That is why it could be a better idea to invest in themoney market, since the risk is lower in the short-term. There are a variety of ways in which a business or private investor can diversify their portfolioin order to alleviate certain risks inherent to a specific country’s role in global financial markets.Citigroup, for example, offers local currency funding and foreign exchange transactions to counterexchange rate risk as well as cash management services to counter a country’s sovereign risk, to namea few.5 Within the stock market, there are also certain regulations in place to maintain order and ensureadequate liquidity. Organized exchanges such as the New York Stock Exchange (NYSE) haveminimum requirements of outstanding shares, earnings and cash flow during recent periods. Agenciesregulating trade in over-the-counter markets such as the National Association of Securities Dealers3 “Fundamentals of Corporate Finance”, Brearley, Myers, Marcus, 6th Ed. Chapter 11, page 3244 „Financial Institutions & Markets“, Madura, 9th Ed. Chapter 11. Stock prices may be affected by country risks such aseconomy and market.5 Ibid, Ch. 17 pg 478.
Country Risk Management in Global Financial Markets Alina Sachapow, Gloria Armesto & Navi Phifer 20 Dec 2011Automatic Quotations (Nasdaq) have recently been merging with their on-the-floor counterparts inorder to ensure less discrepancy between regulations in the different markets.6 A third method used to counter exposure risk to movements in security prices is hedging,investing in Derivative Securities (DS) such as futures, forwards, and options.7 DS can be used in amanner that will generate gains if the value of the underlying asset declines, such as taking a futuresposition to sell securities at a certain fixed price in the future, regardless of the actual market price atthe date of sale. DS can be used to reduce market exposure to interest rate risk, unexpected industry“bubbles” and also unforeseen factors such as natural disasters which is worth considering in the caseof Japan. Though DS can be helpful in reducing risk, an investor should take caution of this double-edged sword being used to also drive up stock prices far higher than their fundamental prices.8 Last but certainly not least, an international investor needs to constantly monitor their portfolioand adjust as conditions change. Even the risk-free rate can be affected by several factors, such asinflationary expectations, economic growth, money supply growth and budget deficit. Situations thatonce seemed promising and safe may no longer be so and countries that once seemed too risky mightnow be viable investment candidates. Though there are a wide variety of methods and options usedtoday to manage country risk in global financial markets, none of them are one hundred percentaccurate. An investor should always keep this in mind when “gambling” with international financialmarkets.6 Ibid, Ch. 10 pg 244.7 Ibid, Ch. 13 pg 325.8 Ibid, Ch. 14 pg 378